Aswath Damodaran

CAPITAL STRUCTURE: THE CHOICES AND THE TRADE OFF

Neither a borrower nor a lender be Someone who obviously hated this part of corporate nance

First principles
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Aswath Damodaran

The Choices in Financing

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There are only two ways in which a business can make money. The rst is debt. The essence of debt is that you promise to make xed payments in the future (interest payments and repaying principal). If you fail to make those payments, you lose control of your business. The other is equity. With equity, you do get whatever cash ows are leQ over aQer you have made debt payments.

Aswath Damodaran

Global PaSerns in Financing

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Aswath Damodaran

And a much greater dependence on bank loans outside the US

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Aswath Damodaran

Assessing the exisUng nancing choices: Disney, Aracruz and Tata Chemicals
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Aswath Damodaran

Financing Choices across the life cycle

Revenues $ Revenues/ Earnings Earnings

Time

External funding needs

High, but constrained by infrastructure

High, relative to firm value.

Moderate, relative to firm value.

Declining, as a percent of firm value

Low, as projects dry up.

Internal financing

Negative or low Owners Equity Bank Debt Stage 1 Start-up

Negative or low

Low, relative to funding needs Common stock Warrants Convertibles Stage 3 High Growth

High, relative to funding needs Debt

More than funding needs

External Financing Growth stage

Venture Capital Common Stock Stage 2 Rapid Expansion

Retire debt Repurchase stock Stage 5 Decline

Stage 4 Mature Growth

Financing Transitions

Accessing private equity

Inital Public offering

Seasoned equity issue

Bond issues

The TransiUonal Phases..

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The transiUons that we see at rms from fully owned private businesses to venture capital, from private to public and subsequent seasoned oerings are all moUvated primarily by the need for capital. In each transiUon, though, there are costs incurred by the exisUng owners:

When venture capitalists enter the rm, they will demand their fair share and more of the ownership of the rm to provide equity. When a rm decides to go public, it has to trade o the greater access to capital markets against the increased disclosure requirements (that emanate from being publicly lists), loss of control and the transacUons costs of going public. When making seasoned oerings, rms have to consider issuance costs while managing their relaUons with equity research analysts and rat
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Aswath Damodaran

Measuring a rms nancing mix

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The simplest measure of how much debt and equity a rm is using currently is to look at the proporUon of debt in the total nancing. This raUo is called the debt to capital raUo: Debt to Capital RaUo = Debt / (Debt + Equity) Debt includes all interest bearing liabiliUes, short term as well as long term. Equity can be dened either in accounUng terms (as book value of equity) or in market value terms (based upon the current price). The resulUng debt raUos can be very dierent.
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Aswath Damodaran

The Financing Mix QuesUon

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In deciding to raise nancing for a business, is there an opUmal mix of debt and equity?
If yes, what is the trade o that lets us determine this

opUmal mix?
n

What are the benets of using debt instead of equity? n What are the costs of using debt instead of equity?
If not, why not?

Aswath Damodaran

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Costs and Benets of Debt

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Benets of Debt
Tax Benets Adds discipline to management

Costs of Debt
Bankruptcy Costs Agency Costs Loss of Future Flexibility

Aswath Damodaran

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Tax Benets of Debt

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When you borrow money, you are allowed to deduct interest expenses from your income to arrive at taxable income. This reduces your taxes. When you use equity, you are not allowed to deduct payments to equity (such as dividends) to arrive at taxable income. The dollar tax benet from the interest payment in any year is a funcUon of your tax rate and the interest payment:

Tax benet each year = Tax Rate * Interest Payment

ProposiUon 1: Other things being equal, the higher the marginal tax rate of a business, the more debt it will have in its capital structure.
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Aswath Damodaran

The Eects of Taxes

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a. b. c.

You are comparing the debt raUos of real estate corporaUons, which pay the corporate tax rate, and real estate investment trusts, which are not taxed, but are required to pay 95% of their earnings as dividends to their stockholders. Which of these two groups would you expect to have the higher debt raUos? The real estate corporaUons The real estate investment trusts Cannot tell, without more informaUon
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Aswath Damodaran

Debt adds discipline to management

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If you are managers of a rm with no debt, and you generate high income and cash ows each year, you tend to become complacent. The complacency can lead to ineciency and invesUng in poor projects. There is liSle or no cost borne by the managers Forcing such a rm to borrow money can be an anUdote to the complacency. The managers now have to ensure that the investments they make will earn at least enough return to cover the interest expenses. The cost of not doing so is bankruptcy and the loss of such a job.

Aswath Damodaran

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Debt and Discipline

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a.

b.

c.

Assume that you buy into this argument that debt adds discipline to management. Which of the following types of companies will most benet from debt adding this discipline? ConservaUvely nanced (very liSle debt), privately owned businesses ConservaUvely nanced, publicly traded companies, with stocks held by millions of investors, none of whom hold a large percent of the stock. ConservaUvely nanced, publicly traded companies, with an acUvist and primarily insUtuUonal holding.
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Aswath Damodaran

Bankruptcy Cost
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The expected bankruptcy cost is a funcUon of two variables--

the probability of bankruptcy, which will depend upon how uncertain you are about future cash ows the cost of going bankrupt n direct costs: Legal and other Deadweight Costs n indirect costs: Costs arising because people perceive you to be in nancial trouble

ProposiUon 2: Firms with more volaUle earnings and cash ows will have higher probabiliUes of bankruptcy at any given level of debt and for any given level of earnings. ProposiUon 3: Other things being equal, the greater the indirect bankruptcy cost, the less debt the rm can aord to use for any given level of debt.
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Aswath Damodaran

Debt & Bankruptcy Cost

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a. b. c.

Rank the following companies on the magnitude of bankruptcy costs from most to least, taking into account both explicit and implicit costs: A Grocery Store An Airplane Manufacturer High Technology company

Aswath Damodaran

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Agency Cost
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An agency cost arises whenever you hire someone else to do something for you. It arises because your interests(as the principal) may deviate from those of the person you hired (as the agent). When you lend money to a business, you are allowing the stockholders to use that money in the course of running that business. Stockholders interests are dierent from your interests, because

You (as lender) are interested in gelng your money back Stockholders are interested in maximizing their wealth InvesUng in riskier projects than you would want them to Paying themselves large dividends when you would rather have them keep the cash in the business.

In some cases, the clash of interests can lead to stockholders

ProposiUon 4: Other things being equal, the greater the agency problems associated with lending to a rm, the less debt the rm can aord to use.

Aswath Damodaran

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Debt and Agency Costs

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Assume that you are a bank. Which of the following businesses would you perceive the greatest agency costs? a. A Large technology rm b. A Large Regulated Electric UUlity Why?

Aswath Damodaran

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Loss of future nancing exibility

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When a rm borrows up to its capacity, it loses the exibility of nancing future projects with debt. ProposiUon 5: Other things remaining equal, the more uncertain a rm is about its future nancing requirements and projects, the less debt the rm will use for nancing current projects.

Aswath Damodaran

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What managers consider important in deciding on how much debt to carry...

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A survey of Chief Financial Ocers of large U.S. companies provided the following ranking (from most important to least important) for the factors that they considered important in the nancing decisions
Factor 1. Maintain nancial exibility 2. Ensure long-term survival 3. Maintain Predictable Source of Funds 4. Maximize Stock Price 5. Maintain nancial independence 6. Maintain high debt raUng 7. Maintain comparability with peer group Ranking (0-5) 4.55 4.55 4.05 3.99 3.88 3.56 2.47
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Aswath Damodaran

Debt: Summarizing the trade o

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Aswath Damodaran

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The Trade o for three companies..

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Item Tax benefits Disney Significant. The firm has a marginal tax rate of 38%. It does have large depreciation tax shields. Benefits will be high, because managers are not large stockholders. Movie and broadcasting businesses have volatile earnings. Direct costs of bankruptcy are likely to be small, but indirect costs can be significant. High. Although theme park assets are tangible and fairly liquid, is much more difficult to monitor movie and broadcasting businesses. Low in theme park business but high in media businesses because technological change makes future investment uncertain. Aracruz Significant. The firm has a marginal tax rate of 34%, as well. It does not have very much in noninterest tax shields. Benefits are smaller, because the voting shares are closely held by insiders. Variability in paper prices makes earnings volatile. Direct and indirect costs of bankruptcy likely to be moderate, since assets are marketable (timber, paper plants) Low. Assets are tangible and liquid. Tata Chemicals Significant. The firm has a 33.99% tax rates It does have significant noninterest tax shields in the form of depreciation. Since the Tata family runs the firm, the benefits from added discipline are small. Firm is mature, with fairly stable earnings and cash flows from its chemicals and fertilizer business. Indirect bankruptcy costs should be low, since physical assets are marketable. Biggest concern is that debt may be utilized in other (riskier) Tata companies.

Added discipline Bankruptcy costs

Agency costs

Flexibility needs

Low. Business is Low. Tata Chemicals mature and is a mature company investment needs are with established well established. reinvestment needs.

Aswath Damodaran

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ApplicaUon Test: Would you expect your rm to gain or lose from using a lot of debt?
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Considering, for your rm,

The potenUal tax benets of borrowing The benets of using debt as a disciplinary mechanism The potenUal for expected bankruptcy costs The potenUal for agency costs The need for nancial exibility

Would you expect your rm to have a high debt raUo or a low debt raUo? Does the rms current debt raUo meet your expectaUons?

Aswath Damodaran

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A HypotheUcal Scenario
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Assume that you live in a world where

(a) There are no taxes (b) Managers have stockholder interests at heart and do whats best for stockholders. (c) No rm ever goes bankrupt (d) Equity investors are honest with lenders; there is no subterfuge or aSempt to nd loopholes in loan agreements. (e) Firms know their future nancing needs with certainty

What happens to the trade o between debt and equity? How much should a rm borrow?
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Aswath Damodaran

The Miller-Modigliani Theorem

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In an environment, where there are no taxes, default risk or agency costs, capital structure is irrelevant. If the Miller Modigliani theorem holds: A rm's value will be determined the quality of its investments and not by its nancing mix. The cost of capital of the rm will not change with leverage. As a rm increases its leverage, the cost of equity will increase just enough to oset any gains to the leverage.

Aswath Damodaran

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What do rms look at in nancing?

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There are some who argue that rms follow a nancing hierarchy, with retained earnings being the most preferred choice for nancing, followed by debt and that new equity is the least preferred choice. In parUcular,
Managers value exibility. Managers value being able to use capital (on new investments or assets) without restricUons on that use or having to explain its use to others. Managers value control. Managers like being able to maintain control of their businesses.

With exibility and control being key factors:

Would you rather use internal nancing (retained earnings) or external nancing? With external nancing, would you rather use debt or equity?

Aswath Damodaran

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Preference rankings long-term nance: Results of a survey

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Ranking
1
2
3
4
5
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Aswath Damodaran

Source

Retained Earnings
Straight Debt
Convertible Debt
External Common Equity
Straight Preferred Stock
Convertible Preferred

Score

5.61
4.88
3.02
2.42
2.22
1.72

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And the unsurprising consequences..

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Aswath Damodaran

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Financing Choices
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a. b. c.

You are reading the Wall Street Journal and noUce a tombstone ad for a company, oering to sell converUble preferred stock. What would you hypothesize about the health of the company issuing these securiUes? Nothing Healthier than the average rm In much more nancial trouble than the average rm
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Aswath Damodaran